Mutually Assured Destruction

by | Sep 9, 2003 | POLITICS

For all the outrage and indignation voiced by the media and our public servants, the market didn’t seem terribly concerned by last week’s scandalous revelation that a hedge-fund manager had illegally profited at the expense of mutual-fund shareholders. That’s powerful testimony to the fact that the great bear-market really is over. Just think about it: […]

For all the outrage and indignation voiced by the media and our public servants, the market didn’t seem terribly concerned by last week’s scandalous revelation that a hedge-fund manager had illegally profited at the expense of mutual-fund shareholders. That’s powerful testimony to the fact that the great bear-market really is over. Just think about it: Can you imagine the pandemonium if this scandal had broken a year ago?

That’s the good news — and as readers of this column know, I’ve been arguing since early spring that good news of all kinds was going to keep moving the market higher. That’s just what has happened, and there’s more to come. But don’t let that blind you to the potential bad news in this hedge-fund/mutual-fund scandal.

With so many millions of Americans investing in mutual funds, regulators and dozens of state attorneys general aren’t going to be able to resist the political bonanza of a full-scale investigation of potential abuses in the fund industry. They’re going to find that the fund industry is, indeed, chock full of abuses. Not big abuses, but lots and lots of tiny little abuses that have accumulated gradually over the years, and all for what seemed like perfectly good reasons at the time.

Let me give you a couple of examples. But first, let’s look at what this week’s scandal was all about. The key abuse was that a hedge fund was allowed to buy and sell shares of several mutual funds after the stock market had already closed and the value of the fund shares were set — and other shareholders were no longer able to make such transactions. That harmed ordinary fund shareholders in two ways.

First, say some very bullish market-moving event happened after the close, and it was a cinch that the market would open higher tomorrow. The hedge fund could buy fund shares at prices set before the news came out, and sell higher the next day. Other shareholders in the fund would have their gains reduced because the hedge fund would have taken some of them.

Second, the hedge fund was allowed to make these and other frequent transactions without fully compensating the fund for all of the trading costs involved. That’s like getting all the fund’s normal shareholders to pick up the tab for the hedge fund’s commissions.

It’s all about one shareholder getting special treatment at the expense of all the other guys. Well, various benign and not-so-benign versions of this happen all the time in just about every mutual fund.

Consider the matter of trading costs. There’s no escaping the fact that any fund shareholders who frequently trade fund shares impose asymmetrical costs on shareholders who simply buy and hold, even when the frequent trading isn’t otherwise abusive. A handful of funds charge transaction costs to approximately correct this. But most just impose informal limits on the frequency of trading, without levying any actual charges. The informality and inadequacy of these limits, their poor disclosure to fund shareholders, and the lack of rigor with which they’re applied could be fertile ground for claims of abuse.

Consider what happens when a shareholder pays for shares by check. Typically he’ll become effectively invested the day his check arrives in the mail. But the fund doesn’t get any actual cash until the check clears. In the meantime, the shareholder who paid by check has gotten what amounts to an interest-free loan from the fund. And what happens if the check never clears? Typically the share transaction is simply cancelled — if the market has moved lower and there’s a loss, the fund eats it. Again, fertile ground for claims of abuse.

And how about being able to trade fund shares after the close? Most people don’t realize that it’s actually quite common. It is standard operating procedure in much of the 401(k) and “mutual-fund marketplace” businesses. In both cases, administrators require normal shareholders to have their orders in by the market close. But of necessity, the administrator can transmit those orders to the mutual funds only after the close. In fact, in the case of 401(k) plans, the administrator often requires that a fund’s net asset value for the day be provided by the fund before the order can be placed — necessitating a delay of several hours.

Are there abuses of trading after the close in 401(k) plans or mutual-fund marketplaces? Probably not much, if any — but it’s an under-regulated part of the system and overzealous investigators will realize the potential is there and maybe find something.

And here’s another one. It’s a well-kept secret of the mutual-fund industry that daily fund net asset values don’t accurately reflect the true value of the fund’s holdings. Because of the necessity to provide the NAV within hours of the market close, most funds calculate NAVs using today’s prices applied against yesterday’s portfolio holdings. This creates another opportunity for effectively trading after the close for investors who have inside information about fund holdings, as apparently was the case with the hedge fund involved in this week’s scandal.

If an investigation ends up characterizing these longstanding and widespread micro-abuses as crimes, the price to the industry could be a lot higher than just a stiff fine paid to Eliot Spitzer, or even the endless plaintiff litigation that would no doubt follow. For one thing, there would be massive reputation damage to the fund industry that would set it back decades. And that would spill over into a distrust of the market overall.

But here’s the worst-case nuclear-winter scenario that I’m sure fund-industry executives are talking about secretly right now — and hoping that no one will mention in public. Well, here goes.

The whole mutual-fund industry is based on a tax exemption — and that exemption could be put at risk in a widespread investigation. You don’t think much about it, because if you hold a mutual fund outside an IRA or 401(k), you’re paying taxes every year on its dividends and capital gains (unless it invests entirely in municipal bonds, of course). But the fund itself is tax exempt. Unlike other corporations — and a corporation is what a mutual fund actually is — a mutual fund itself does not pay taxes.

To earn the exemption, a fund must comply with applicable provisions of the Internal Revenue Code. The critical provision here is that all fund shareholders must be treated completely equally. The whole point of this week’s scandal is that certain funds have apparently not been doing that. If the Internal Revenue Service so chose, it could yank the funds’ exemptions — and it could do the same for any fund found to be treating its shareholders unequally in any future investigation.

A mutual fund that loses its tax exemption is, effectively, sentenced to death. Investors would desert funds in droves, and choose instead to hold individual stocks. Why be taxed twice when you can just be taxed once?

But it gets worse. What if the IRS were to rule that a fund had been treating investors unequally for a long period — and seek back taxes and penalties? Technically the fund itself would be liable, and it might be a liability that could more than wipe out all the fund’s assets. Think about the case of a fallen-angel technology fund that racked up big profits in the late 1990s, but now is only a fraction of its former size? The taxes and penalties could be larger than all the assets currently in the fund.

As a practical matter, the fund itself would probably not end up paying the back taxes and penalties. Any mutual-fund company that wanted to stay in the business would no doubt decide to step up to the plate and pay. But the bill could run to billions, and could deal a blow to some fund companies from which it would take years to recover.

How likely is that worst-case scenario? Not very. But I bring it up to make sure you know even the remote risks that are lurking out there.

And I have another reason, too. In a world that sometimes seems full of corporate crooks, our first impulse is to shout “hang ’em high” and applaud the regulators and the states attorneys general as they all rush in to prosecute at the same time. But a little of that goes a long way. What starts out as enforcement can easily turn into a lynch mob.

So now, as the prosecutorial posse goes after the mutual-fund outlaws, be careful before you cheer them on. Watch carefully to see if the abuses they uncover are substantive — and whether it costs more to fix them than it did to live with them. And let’s all take care that we don’t pay the highest price of all: blundering in with guns blazing, and inadvertently destroying the industry that has done a better job than any other to bring ordinary people into the investor class.

Originally published on

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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